Financial assets/Instruments

Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in the form of currency; debt (bonds, loans); equity (shares); or derivatives (options, futures, forwards).

International Accounting Standards IAS 32 and 39 define a financial instrument as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity”.

Financial instruments may be categorized by “asset class” depending on whether they are equity-based (reflecting ownership of the issuing entity) or debt-based (reflecting a loan the investor has made to the issuing entity). If the instrument is debt it can be further categorized into short-term (less than one year) or long-term. Foreign exchange instruments and transactions are neither debt- nor equity-based and belong in their own category.

Types

Financial instruments can be either cash instruments or derivative instruments:

• Cash instruments: instruments whose value is determined directly by the markets. They can be securities, which are readily transferable, and instruments such as loans and deposits, where both borrower and lender have to agree on a transfer.
• Derivative instruments: instruments which derive their value from the value and characteristics of one or more underlining entities such as an asset, index, or interest rate. They can be exchange-traded derivatives and over-the-counter (OTC) derivatives. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps.

Financial instruments can also be classified based on the asset class, i.e. equity-based and debt-based financial instruments.

Equity-based financial instruments include securities, such as stocks/shares. Also, exchange-traded derivatives, such as equity futures and stock options, fall under the same category.

Debt-based financial instruments, on the other hand, consist of short-term securities, such as commercial paper (CP) and treasury bills (T-bills) which have a maturity period of one year or less.

Cash instruments such as certificates of deposits (CDs) also fall under this category. On the same lines, exchange-traded derivatives, such as short-term interest rate futures fall under this category.

Since the maturity period on long-term debt-based financial instruments exceeds a year, securities such as bonds fall under the category. Exchange-traded derivates include bond futures, and options are the other examples.